Is the Deduction of Interest on Tax Deficiencies Finally Over?

Since the mid-1990s, there has been a plethora of disputes between noncorporate taxpayers and the IRS about the deductibility of interest incurred on income tax underpayments. Prior to the Tax Reform Act of 1986 (TRA '86), taxpayers could deduct substantially all interest. The TRA '86, however, included Sec. 163(h), which disallowed the deduction of personal interest. The issue in dispute since the TRA '86 has been whether or not interest on an underpayment of income tax directly related to a taxpayer's trade or business is deductible. That question now seems to be settled for most taxpayers, but not in their favor.

The Issue

Sec. 163(h) disallows a deduction for personal interest, defined as any interest other than:

• Interest properly allocable to a trade or business;
• Investment interest;
• Interest from a passive activity;
• Qualified residence interest; and
• Interest on an unpaid portion of estate tax for the period during which an extension of time for payment is in effect.

Based on a literal reading of Sec. 163(h), it would appear that interest on a tax deficiency attributable to a taxpayer's sole proprietorship would be deductible, as this interest would be properly allocable to a trade or business.

Example: Taxpayer T's income is derived from operation of a sole proprietorship. His return is audited and a correction to Schedule C income is made. An inventory valuation adjustment or an error in conversion from accrual-basis to cash-basis accounting could be the cause. Additional tax and interest on the underpayment are also due.

The Tax Court took a pro-taxpayer stance, ruling that the interest on the underpayment properly allocable to T's trade or business is deductible. The Service, on the other hand, relied on Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), which states that nondeductible personal interest includes interest on underpayments of Federal income tax, regardless of the source of the income generating the tax liability. This seems to be in conflict with Sec. 163(h)(A), which declares that interest properly allocable to a trade or business is not personal interest.

The Taxpayer's Position

Generally, the argument the taxpayer makes is that (1) historically, interest related to business debt is an ordinary and necessary business expense under Sec. 162 and (2) Sec. 63(a) allows trade or business deductions to arrive at adjusted gross income. While Sec. 163(h) disallows a deduction for personal interest, a specific exception is made for interest properly allocable to a trade or business.

The House Committee Report on the TRA '86 does not clarify the issue. It states that personal interest is no longer deductible, interest incurred in connection with the conduct of a trade or business is not personal interest, and personal interest "generally includes interest on tax deficiencies." "Generally" does not mean "always"; the question is when would interest on tax deficiencies not be personal interest? The Committee Report does not provide the answer. However, the obvious answer would be that, when interest is incurred on a tax deficiency properly allocable to a trade or business, it is no longer personal interest. Case law prior to the TRA '86 consistently ruled in favor of this result; see Standing, 28 TC 789 (1957), aff'd, 259 F2d 450 (4th Cir. 1958); Polk, 31 TC 412 (1958), aff'd, 276 F2d 601 (10th Cir. 1960), and Reise, 35 TC 571 (1961) aff'd, 299 F2d 380 (7th Cir. 1962).

Unfortunately, Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) provides that personal interest includes interest "paid on underpayments of individual Federal, State, or local income taxes and on indebtedness used to pay such taxes...regardless of the source of the income generating the tax liability...."

In Redlark, 106 TC 31 (1996), a divided Tax Court evaluated Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A). The court stated that a temporary regulation is accorded the same weight as a final regulation. However, an interpretive regulation is given less deference than a legislative regulation. An interpretive regulation is upheld only if it is found to implement the congressional mandate in some reasonable manner.

Without specifically stating whether the statute was ambiguous, the Tax Court proceeded with its review of the regulatory framework and legislative history. After citing numerous cases, the court stated that, as applied to the current situation, the temporary regulation was "an impermissible reading of the statute and is therefore unreasonable." The court determined that applying the temporary regulation would eliminate an entire class of deductions by always making interest on tax deficiencies personal nondeductible interest.

A district court in Allen, 987 F Supp 460 (1997), and two concurring opinions in Redlark have been even more bold. These opinions found no ambiguity in the statute allowing deduction of interest properly allocable to a trade or business. Given the ordinary meaning of the term "properly allocable to a trade or business," the temporary regulation must be held invalid.

The Service's Position

The IRS is equally confident about the correct interpretation of the statute and the applicability of the temporary regulation. Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) maintains that, because the statute does not define how interest on indebtedness is properly allocable to a trade or business, it is ambiguous. Therefore, the interpretative regulation is needed. The statute and the Committee Report both state that interest on trade or business debt is not personal interest. Also, the Committee Report declares that personal interest "generally" includes interest on tax deficiencies. An exception is allowed for "deduction of interest on past-due business taxes, such as sales and excise taxes which the regulations specifically exclude from the definition of personal interest" (Redlark, 106 TC 31). The Service maintains that liability for income taxes is strictly personal and, as such, the underpayment interest is personal interest, as explained in the temporary regulation.

As additional support, the IRS points to the TRA '86 "Blue Book," which unequivocally maintains that interest on underpayment of income taxes is nondeductible personal interest, even when the income is derived from the taxpayer's trade or business. (See Karlinsky, "Can an Individual Deduct Interest Paid on a Business-Related Tax Deficiency?," TTA, July 1996, p. 430.)

Recent Decisions

Although trial courts have taken a pro-taxpayer stance, the appellate courts have consistently ruled in favor of the Service. In recent cases, the Fourth (Allen, 173 F3d 553 (1999)), Eighth (Miller, 65 F3d 685 (1995)) and Ninth (Redlark, 141 F3d 936 (1998)) Circuits have all upheld the validity of Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A), pointing to the lack of agreement among justices about the meaning of the statute as proof of its ambiguity. That ambiguity opens the door for evaluating the reasonableness of the temporary regulation. Although the Blue Book does not qualify as legislative history, it clearly indicates that the interest is nondeductible personal interest. Therefore, the IRS's interpretative regulation cannot be construed as unreasonable. The Seventh Circuit, in Kikalos, 190 F3d 791 (7th Cir.1999), rev'g TC Memo 1998-92, quoted from Miller:

Nothing in the temporary regulation is inherently irrational or in conflict with the statutory treatment of interest. The Commissioner has taken the view that because it is the individual in this case who bears the obligation to pay the income tax, the delinquency and the resulting interest are debts that are likewise personal, even if the income derives from the taxpayer's business. That is a reasonable application of the imprecise standard that Congress has set out in the statute.

Proposed Legislation

Congress has not been oblivious to this disagreement. Section 102 of H.R. 4163, the Taxpayer Bill of Rights 2000, addresses the controversy. The "Present Law" section reiterates the Sec. 163(h) prohibition on deducting personal interest. It also asserts that the temporary regulation makes clear that this prohibition applies to interest paid on underpayments of Federal, state or local income taxes, regardless of the source of the income generating the tax liability. In addition, the review points out that Temp. Regs. Sec. 1.163-9T(b)(2)(i)(A) is consistent with the General Explanation of the TRA '86 and that several appellate courts have upheld the regulation.

The "Reasons for Change" section explains that the House Ways and Means Committee believes there should be consistency in the treatment of interest paid by the Federal government and paid by the taxpayer. Therefore, the Committee proposes new Sec. 139 to accomplish this purpose. The new section will exclude overpayment interest from gross income. This exclusion does not apply, however, "if the Secretary determines that the taxpayer's principal purpose for overpaying his or her tax is to take advantage of the exclusion." That is, the taxpayer may not take advantage of Sec. 139 to earn tax-free interest.

The example of abuse describes a taxpayer who files a return without taking advantage of significant itemized deductions "of which he is, or should be, aware," and files an amended return, before the statute of limitations expires, to claim the deductions and request a refund with tax-free interest.

Summary

The disagreement over the de-ductibility of interest on tax deficiencies appears to be at an end. Congress intends to "fix" the problem by adding Sec. 139 to the Code. The House Ways and Means Committee members believe they have provided an equitable solution by allowing interest on tax overpayments to be excluded from gross income. However, the congressional solution to the dispute may breed even more litigation.

From Charles E. Price, Ph.D., CPA, Charles M. Taylor Professor of Taxation, Department of Accountancy, Auburn University, Auburn, AL, and Leonard G. Weld, Ph.D., Chair and E.H. Sherman Professor, Department of Accounting and Finance, Troy State University, Troy, AL (Neither associated with Summit International)